If an investor would like to save for retirement by investing in a Roth account, but she earns too much to contribute directly to a Roth IRA, she may want to use the strategy called a backdoor Roth IRA.

What is a backdoor Roth IRA?

Firstly, a backdoor Roth IRA isn’t a different kind of IRA. It would be more accurate to call it “backdoor” Roth IRA funding or “backdoor” Roth IRA contribution.

It is a strategy that allows high-income earners to fund an Roth IRA, even if their income exceeds the limits set by the IRS for direct (“frontdoor”) Roth IRA contributions.

How the backdoor Roth strategy works

The backdoor Roth IRA contribution strategy involves two main steps:

  1. Contribute to a traditional IRA: First, the individual makes a nondeductible contribution to a traditional IRA. This means she contributes money to the account without claiming a tax deduction for the contribution.

  2. Convert the Funds to a Roth IRA: After the contribution is made, the individual then converts the funds from the traditional IRA to a Roth IRA. The conversion is typically done shortly after the contribution to minimize any potential taxable earnings on the funds before conversion.

As a reminder, consult a tax professional to discuss the timing, potential tax implications, and the specific steps involved in a backdoor conversion as it applies to you.

Tax considerations

The process of calculating the taxes owed on a backdoor Roth IRA conversion can become complex, especially if an investor has multiple traditional IRAs. Taxes on IRA conversions can be significant, if the accounts include more than just nondeductible contributions.

Simple case: no pre-tax dollars nor earnings in investor’s traditional IRAs

If there are no pre-tax dollars nor earnings across an investor’s traditional IRAs, either because she doesn’t have a traditional IRA, or she has only made nondeductible contributions in them, then the tax considerations may be straightforward. While the conversion is a taxable event, there may not be material, if any, tax, because effectively she is moving post-tax dollars from the traditional IRA to the post-tax dollar Roth.

Complex case: pre-tax dollars or earnings in investor’s traditional IRAs

If an investor’s traditional IRAs contain deductible contributions, which are subtracted from her taxable income in the tax year they are made, or investment earnings from either deductible or nondeductible contributions, these amounts are taxable as ordinary income during a Roth conversion at her marginal tax rate or higher. It’s essential the investor understands these tax implications and plan for how she’ll cover the taxes due when you file.

If an individual has multiple traditional IRAs, she would need to determine the composition of contributions in all accounts. These may include:

  • Deductible contributions and earnings, which are taxable during a conversion.
  • Nondeductible contributions, which are not taxable during a conversion.

She cannot selectively convert only your nondeductible contributions. The IRS applies the IRA aggregation rule, which treats all an investor’s traditional IRAs as a single entity when determining the taxable portion of the conversion. The tax liability is calculated based on the proportion of deductible contributions and earnings to nondeductible contributions across all traditional IRAs, excluding inherited IRAs and Roth IRAs.

For example, let’s say Alice has a total of $100,000 across all her traditional IRAs, consisting of 5% nondeductible contributions and 95% deductible contributions. If she were to convert $5,000 to a Roth IRA, 95% of that amount ($4,750) will be taxable.

Consult with a tax professional to help ensure accuracy of reporting and optimize your strategy.

Yes, backdoor Roth IRAs are legal. The backdoor Roth IRA was enabled by Congress as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). TIPRA removed the income limit to perform a traditional to Roth IRA conversion, thereby allowing for high-income earners to convert traditional IRAs in lump sums or an ongoing, “backdoor,” basis.

AnchorZero supports backdoor Roth IRAs

AnchorZero supports backdoor Roth IRAs and makes it easy to execute the backdoor Roth IRA strategy. Get started today.

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Disclaimer

This information herein is not intended to and does not constitute tax, legal, nor investment advice, recommendations, mediation or counseling of any kind, and its content and your use thereof neither creates an attorney-client relationship with AnchorZero nor the author. The information herein is neither endorsed by nor does it necessarily reflect AnchorZero or the author's belief. Neither AnchorZero nor the author warrants or guarantees the accurateness, completeness, adequacy or currency of the information herein. Those seeking tax, legal or investment advice (including, but not limited to, advice concerning IRS disclosures, prohibited transactions, valuations, and unrelated business income tax) should consult with their own tax attorney or other financial professional. Any information communicated by AnchorZero is solely for educational purposes and should not be construed or relied upon as legal or tax advice. Consultation with tax and legal professionals is advised prior to making any decisions.